In his 1978 HarvardUniversity honors thesis, The Ideology and Politics of Old Age Insurance in the United States, Jack Lew
submitted his ideas on Old Age & Survivors Insurance (OASI) -- Social Security.
Long before he was tapped to become the Secretary of the Treasury in the
Obama administration, he was looking critically at some of the most fundamental
issues facing the American economy.

As with
scientists, it may be true that young economists experience their greatest
insights before growing their first gray hair.
Lew correctly observed that the threat of communism was
overestimated. He alleged that the
funding mechanism for OASI was a regressive tax that poorly served the US
economy. And he suggested that
progressive income taxes should replace payroll taxes to fund both Social
Security and Medicare.

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GRADE HIS PAPER

Was he
right? To determine whether or not OASI
funding and payroll taxes in general are regressive, several aspects must be
examined: the perspective of individual
workers; the aggregate perspective of consumers; and the flow of cash
throughout the economic system. And what
would be the impact of replacing the existing payroll tax with a progressive
income tax to fund these benefits?

Payroll taxes are
indeed regressive when viewed from the perspective of employed individuals. They fall most heavily upon those who work
and earn their income by the sweat of their brow. They only minimally affect those who earn
their income passively, through rents, royalties, dividends, interest, or
capital gains. If this structural
inequity were not enough, the incremental burden of the Social Security payroll
tax is entirely removed from those whose earnings exceed $117,000.

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WHAT DID HE MISS?

When the OASI
program is viewed from the perspective of aggregate consumer spending, the
picture changes. Retirees realize increases
in their income, so they will view payroll taxes as quite progressive. Retired elders as a demographic have lower
incomes than their younger counterparts, and their old age benefits from Social
Security reduce income inequality.
However, the same demographic enjoys relatively higher levels of wealth,
and in this view adding income is actually regressive. But given that the marginal propensity to
spend is greater for retired elders than it is for their younger and employed
benefactors, OASI is modestly progressive with respect to aggregate spending.

A look at the
cash flows of the Social Security funding system should make us worried. Maybe even a little embarrassed. The OASI Trust Fund, from its very inception,
has received more in payroll taxes and other income than it has paid out in
total benefits and expenses. The balance
in the fund at the end of 2012 stood at $2,600,000,000,000 -- and it's still
rising. This money doesn't just sit
there, but is instead swapped for treasury securities. But there's a middleman in the form of the
Federal Reserve, which removes the cash from the trust fund and distributes it
to its member banks to lend to corporations and others. In recent years, the securities swapped out
for the cash have yielded a pitifully low return. This redistribution does not promote income or wealth equality, but rather promotes the
collection, formation, and deployment of capital within the economy.

When capital
formation is, in effect, subsidized by the transfer of cash by the Federal
Reserve from the SS trust fund to banks and corporations, the balanced
competition between capital and labor is disrupted. In a healthy economy, capital and labor
compete fairly and evenly. Profits and
labor costs are natural enemies. Capital
investment aimed at efficiency and/or capacity expansion reduces the labor content
of products and services. This increases
the aggregate supply of labor in the economy.
Wages decline and unemployment rises as a consequence of this indirect
but very real subsidy of capital flowing out of the OASI trust fund. And it's very
regressive.

THE REAL PROBLEM WITH SOCIAL SECURITY

What's worse than
subsidizing capital formation? Taxing employment! Every time an employer wants to fill a job, it
must pay a big surcharge to the federal government. Payroll taxes, starting from dollar one at a
rate of 15.3%, raise the price of labor and discourage its use in favor of
automation, which requires capital, which in turn is subsidized. Herein
lies the real problem with OASI funding.
Raising the price of any commodity will reduce its demand, and labor is
no exception. This being true, we would
expect to see stubborn unemployment even as corporate profits grow unabated,
and we observe these very things in
today's economy. The payroll tax
that funds Social Security is literally and directly a job killer!

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THE OBVIOUS SOLUTION

Here's where Jack
Lew got it right. To fund OASI, simply
ditch the payroll tax in favor of a progressive income tax! It could be done, even three decades after
Lew's thesis. And with a few tweaks, it
could be done without increasing the federal deficit. Here's the form that such a solution might
take.

First, eliminate
all federal payroll taxes. Second, tax
corporations at a rate of 30% of income based upon generally accepted
accounting principles (GAAP) net of dividends paid to US taxpayers. Third, tax individual incomes from any
source, net of a universal $20,000 standard deduction, at progressive rates of
20%, 25%, 30%, 35%, and 40%, with each rate corresponding to 1/5 of earners --
quintiles. Now we're about $130 billion
short of revenue neutrality -- that point at which the deficit doesn't
change. To recognize that the American
economy has favored wealth and capital for centuries -- and failed to adopt Jack
Lew's solution in 1978 -- a modest tax of 15% on the nonresidential value of individual
estates over $500,000 would bring the figures into balance.

Thirty five years as a small business consultant, CFO, and university educator specializing in quantitative business and economic modeling - a suite of experience now focused on economic inequality. Carefully attributed data, thoughtful (more...)